Finding the Right Tobacco Stock for a Growing Dividend

Altria, Philip Morris International, and Lorillard each offer a distinct investment option. Altria operates in the mature domestic market, Philip Morris in the growing international market, and Lorillard dominates the menthol market. Which one offers the best value?

There are few industries which provide higher dividend yields to investors than the tobacco industry. But with the United States being a mature market, companies focused on international markets look more appealing. Philip Morris International(NYSE:PM), spun off from Altria(NYSE:MO) in 2008, sells its products strictly outside of the United States. With markets in Asia driving growth, Philip Morris is in prime position to capitalize on growing populations and economies.

But in return for this higher growth, investors accept a lower dividend yield. Is Philip Morris really the best option, or does Altria, or smaller competitor Lorillard(NYSE:LO), offer better value?

Three distinct optionsWhile these businesses aren't the only cigarette companies around, they offer three very different options for investing in the tobacco industry. Here's a quick overview of all three. Revenue and net income are in billions USD.

Company

Market

Revenue

Net Income

Forward P/E

Dividend Yield

Payout Ratio

Altria

U.S.

$17.50

$4.18

14.5

5.54%

82.5%

Philip Morris

International

$77.39

$8.80

16.1

4.29%

59.9%

Lorillard

U.S.-Menthol

$6.62

$1.10

14.4

4.87%

73.6%

Domestic giantAltria operates strictly in the U.S. after spinning off its international operations, it owns well-known brands like Marlboro and Parliament. Marlboro accounts for a staggering 43.6% of the domestic cigarette market, with all Altria brands combined claiming 50.3% of the market.

The U.S. market is both mature and highly regulated, making future growth for Altria slow at best. The company pays out over 80% of its earnings, as there are few investment opportunities for the company. The company's profit margins are lush, about 24% in 2012, and the last dividend increase was about 9%. Going, forward, both earnings and dividends should grow in the mid single digits.

Altria trades at a lower forward P/E than the faster-growing Philip Morris International while paying a significantly higher dividend. Altria yields 5.54%, the highest of the three companies.

International behemothPhilip Morris International sells many of the same brands sold by Altria, only outside the U.S. Marlboro is also the most popular brand internationally, bigger than the next two largest brands combined. Other popular Philip Morris brands include L&M, Bond Street, and Lark.

Without operations in the U.S., Philip Morris isn't subject to the same intense regulatory scrutiny that Altria must endure. Regulations in many of Philip Morris's markets are far more lax, and with volumes growing in many Asian countries, the company is poised to grow much faster than its U.S. counterpart.

Philip Morris only pays out about 60% of its earnings as dividends, with a lower yield of 4.29% compared to Altria. The company does actively buy back its own shares, with over $3 billion spent so far this year. The last dividend increase was a solid 10.6%, and going forward; dividend hikes should be in the high single digits or the low double digits.

A one hit wonder?Lorillard is the wildcard in all of this. The company is small, with just $6.6 billion of revenue in 2012, and most of its sales come from a single product. Newport cigarettes, which are menthol-flavored, make up about 90% of Lorillard's sales. This is a problem because the Food and Drug Administration announced in July that it would consider new regulations on menthol-flavored cigarettes.

The worst-case scenario, of course, would be an outright ban. This in unlikely, but any new regulation would hurt Lorillard's sales. The company is trying to diversify, acquiring an e-cigarette company last year, and another one earlier this month, but Newport will remain its main business for the foreseeable future.

The stock is priced at about the same multiple as Altria, although Lorillard offers a lower dividend yield. It's up considerably since the beginning of the year, and with the risk of menthol regulations looming, it's hard to recommend the stock at these prices. Earlier in the year the dividend was closer to 5.5%, making the stock more compelling, but now that Altria pays a considerably higher dividend, Lorillard doesn't look as attractive.

Foolish bottom lineBoth Altria and Philip Morris International are reasonable buys at current prices. For those looking for income, Altria offers an extremely high yield, adequate dividend growth, along with a dominant, defensible market share. Those willing to accept a lower yield for better growth prospects should turn to Philip Morris International.

Lorillard needs to be cheaper to compensate investors for the regulatory risk. Although the e-cigarette push is promising, it will take many years for the company to adequately diversify beyond the Newport brand. You should stick to the bigger companies for now.